By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

The Federal Reserve Bank of Boston recently published a paper titled: “Reasonable People Could Disagree: Optimism and Pessimism About the US Housing Market Before the Crash.” The paper proposes two interrelated standards by which the Fed’s role in the run-up to the recent crisis can be judged. The authors “conclude by arguing that economic theory provides little guidance as to what should be the correct level of asset prices – including housing prices. Thus, while optimistic forecasts held by many market participants in 2005 turned out to be incorrect, they were not ex ante unreasonable.” The implied pass issued to the Fed for having missed the housing bubble elicited much anger and consternation from bloggers and others. Much, but not all of the criticism was directed at the failure of the Fed to recognize the bubble for what it was and for the paper’s denial of the Fed’s responsibility for its contribution to the crisis. The relatively narrow focus of the responses is unfortunate. A brief analysis of the lines of argument advanced by the authors reveals weaknesses in the argument and a decided shortcoming in the Fed’s approach to policy formulation prior to the crisis.

As part of the first standard (consensus of economists) by which the Fed’s role can be judged, the authors argued that economists were divided over the existence of a housing bubble:

i) some economists believed and argued that a bubble existed – the pessimists;
ii) a larger group of economists did not believe a bubble existed – the optimists;
iii) most economists were agnostic on whether or not a bubble existed.

Based on the divisions among economists and the high concentration of agnostics, the authors drew their conclusion: given the absence of a consensus it was not unreasonable for the Fed to adhere to the optimistic view — there is no bubble. This line of reasoning assumes that it is appropriate for a policymaker at the Fed to view and react as economists would, however nothing could be farther from the truth.

Economists have every right to hold any opinion about markets that they choose, they have every right to express it, and they have every right to be agnostic about any or every policy or issue. However, as economists they have no responsibility except to themselves and their careers. In fact, the paper suggested that most economists decided not to take a position on the existence of the housing bubble because of reputational risk, i.e., they were afraid to be wrong.

The Fed (and economic policymakers in general) is in a very different position. It does not have a right to have an opinion or not; it has a responsibility: promoting full employment and price stability. Asset prices are drivers of economic activity — business investment, residential investment, and consumption as well as determining the value of collateral that supports the financial system. Consequently, the Fed cannot fulfill its mandate by being agnostic about the possible existence of macro-economically important asset price bubbles or other economic or financial imbalances. In order to meet its responsibility, the Fed must incorporate the possible existence of an asset bubble or imbalance in to the policy formulation process. The fact that economists had not reached a consensus on the existence of a housing price bubble is irrelevant to the assessment of the Fed’s role prior to the crisis.

In the second proposed economic policy evaluation standard, the authors argued that economics did not provide an analytically based means of identifying asset price bubbles. (The consensus of economists’ standard discussed above may be viewed as a corollary of this standard.) The authors argued that economic theory of asset prices is insufficiently well developed to distinguish “bubble” prices from equilibrium or near-equilibrium prices. The authors then go on to argue that this represents a theoretically based justification for both economists to have been agnostic and the Fed to have been acting reasonably when it failed to see and respond the housing bubble. (Note: At the time that the Boston paper was published, Fed officials were actively arguing that there was no bubble in the prices of Treasuries.)

While the Boston Fed paper is correct in that asset price theory does not provide a means to identify bubbles with any degree of certainty, it also ignores an equally important point. Asset price theory could not rule out the existence of the bubble with certainty either. Given the absence of certainty, the process of weighing the merits of alternative policies and choosing between them should reflect the examination and weighting of all possible outcomes across all the possible policy choices and possible states of the world and not simply the outcomes associated with the assumed to be most likely current states of the world (e.g. there is no housing price bubble).

However, history suggests that the Fed assigned a higher probability to the non-existence of the bubble than it did to the existence of the bubble and then continued to set policy and otherwise act as if it knew with certainty that no bubble existed. This is reflected in policy stances (monetary and regulatory), the language in speeches given by members of the FOMC and is also consistent with the argument presented in the Boston Fed paper. If so (and the evidence indicates it was), then the Fed shirked its responsibility. In particular, evidence is consistent with the position that the Fed failed to include in its policy calculus the answer to a question that it should have, but presumably never got around to asking: What would be the implications for the housing market, the real economy, financial markets and institutions, if the Fed continues to set policies assuming that there is no bubble in real estate prices when in fact there is an unsustainable price bubble?

If the Fed had employed its tools and powers as a regulator and supervisor to research the answer to some a few aspects of that question, it would have discovered that many important players, including major financial institutions that it regulated, were not just “optimists”, but were increasingly highly leveraged, maturity-mismatched, bet-the-firm “optimists”. (Note: the Fed has argued that information it gleans as a regulator is important in the formulation of monetary policy. In fact, this is the principle argument it has used for retaining a regulatory role.) It also would have been able to make educated guesses about the risks inherent in some bank counterparty positions.

Combining the information available to it as a regulator with information from other regulators and publicly available information on the size of down payments, negative amortization loans, teasers rates etc., the Fed would then have been able to assess the risk it was running when it continued to set policies assuming that there was no bubble in real estate prices. It would have been in a position to foresee some of the implication of a future end to house price appreciation for mortgage defaults, losses given default, the mortgage market, the housing market, the real economy, as well as on financial instruments, markets and institutions. It would have been able to recognize the possibility of a self-reinforcing downward pressure on the prices of housing and housing-related assets that would have manifested themselves if price appreciation faltered for any reason.

If the Fed had performed the analysis, it would have discovered at least some of the growing fault lines running through the housing market and the financial system. Enough relevant information was available to the Fed to set off policy alarm bells. If the Fed had done this research, it would not have been surprised by the crisis. Had the Fed performed the analysis, it is likely that monetary and or regulatory policies would have been different than they were.

In short, history supports the argument that the Fed decided that the probability of the existence of a real estate price bubble was less than the probability of no price bubble and that it never assessed the costs to society that would arise if it continued to set policy predicated on sustainable real estate prices when in fact there was a price bubble. As a result, it incorrectly estimated the expected pay-off to maintaining policy stances that assumed no real estate bubble existed as well as underestimating the risks associated with those policy stances.

Back to the Boston Fed paper, the absence of an analytic “solution” to the question “Is there an asset price bubble?” is largely irrelevant in assessing the Fed’s role prior to the crisis. The Fed failed to ask the correct questions. There were other perspectives and tools available. The Fed did not exhaust them.
Policymakers must be prepared to act when formal economics gives little or no guidance. To do that, policymakers must be willing to make decisions despite the limitations of economics, to use types of information that economists do not use or do not have access to, have the courage to act despite incomplete information and in the presence of risk and Knightian certainty. Policymakers must not assume certainty when there is none. Agnosticism and policymaking do not mix. Policymakers do not have the option of sitting on their hands, hoping for the best while trying to avoiding reputational or political risk. Policymakers cannot escape responsibility for economic underperformance, simply because economics doesn’t provide a simple unambiguous policy rule.

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24 comments

Just more obfuscation trying to cover up criminal ideology, intent, and behavior with armchair psychoanalysis.

We know the Fed sees itself as the enforcer of Wall Street’s prerogative. That’s why it was established in the first place. Its one and only goal under normal cicrumstances is to manage inflation at the level preferred by the big banks. In crisis situations its goal is to bail out the big banks and assist them as disaster capitalists.

That explains everything – the systematic blowing up of the bubble, the systematic lying about it, and the systematic Bailout. (The Bailout at first seemed ad hoc, but the basic guideline is clear: Prop up MBS values and draw the line at whatever would severely hurt Goldman. Once it was clear that AIG would perish and that the contagion had rendered Goldman itself bankrupt, the Fed and Treasury went all in with the Bailout.)

Based on the divisions among economists and the high concentration of agnostics, the authors drew their conclusion: given the absence of a consensus it was not unreasonable for the Fed to adhere to the optimistic view — there is no bubble. This line of reasoning assumes that it is appropriate for a policymaker at the Fed to view and react as economists would, however nothing could be farther from the truth.

IOW once enough people are lying each feels completely absolved of any responsibility whatsoever. It’s a version of the mob mentality, a riot among the elites. (But of course where the elites riot and smash the looting is far more systematic and infinitely greater, as are the lies meant to justify it.)

Economists have every right to hold any opinion about markets that they choose, they have every right to express it, and they have every right to be agnostic about any or every policy or issue.

If that means con men intent on committing fraud have a right to make fraudulent statements (like the way the ratings agencies are claiming a 1st amendment right to issue ratings based on fraud), then I’m afraid I disagree.

And I can’t imagine what else it could mean.

However, as economists they have no responsibility except to themselves and their careers.

If that’s true, and by “economists” we mean persons formally educated by society, in whom society has invested such resources, then why should we tolerate the existence of economists at all?

I know I’m not willing to invest one cent in the “education” of anyone who is then to have no responsibility to anything but his wretched “career”.

The core of all our problems is that we tolerate the existence of such sociopaths in positions of influence. At the very least we shouldn’t educate anyone to become that.

It’s like a big totem pole of economists, each squatting directly on top of the one below, each face looking up and each nose firmly planted in the hole of the ass above. This gives it a stability when the winds of truth blow against it.

All the way from the Fed on down to the junior PhD staffers at the banks.

And all our money just trickles down from ass to nose to ass to nose. And they all get so used to the smell that they think that’s what money smells like — which it does when spirit is taken out of it completely — and they are so successful at self-delusion and self-enrichment they fail completely to comprehend the mind-shit they eat every day.

Well put, but unfortunately you seem to be dealing from a base of solid economic realism, professional responsibility, and moral good sense. You must have missed the memo that these are all passe because WE ARE IN A NEW ERA, or some other horse tripe meant to boondoggle and beguile long enough to steal a few more trillion. Welcome to latter day Nero’s Rome (or is it Caligula?), just in time for me to get my progressive-era desires handed to me, my family, and future generation with the check for the really expensive meal my “friends” at Goldman decided to run up while I was out to the bathroom. The only porcelain they should be seeing is the toilet bowl and not the fine china they’ve bonused themselves after bulloxing it up for every one else.

The Wall Street pay bubble was the housing bubble. You don’t know the car is moving if you don’t look out the window. On mainstreet with stagnant wages since the 70’s, everyone knew that when the ARMs reset, the jig was up.

“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

Alan Greenspan Dec. 5th 1996

Greenspan, for one, would have known real estate was a bubble. He was the one who asked the above question before anyone else. Combine irrational exhuberance with financial engineering run amok = bubble. Seems obvious now.

Mr. Alford,
Your line of thought assumes a Fed free from political influence. The Fed is very highly politically influenced and as such, it would have had difficulty pricking the real estate bubble at an opportune time. The gerrymandered regulatory setting would have also made the problem more difficult to resolve.
We’d have had a different outcome had the Fed fostered a consumer recession in 2001 (but most economists feared the impact of that on top of the dot com bubble collapse), and/or if boards of directors hadn’t allowed managements to sweep away all pretense of credit analysis.
All the players had a stake in perpetuating what turned into a ponzi scheme; and all must share in the blame for what has transpired.

I was going to reply with the same general idea, so let me add my support to stewart (in a way)…

The faulty implication of Mr. Alford’s logic is that had the Fed looked at the problem differently, or asked a different question, the policy response would have been different. The non-response was as much politics as it was economics.

That said, after the fact arguments by Boston Fed economists as to why the non-response was justified is misleading given that the policy relative to house prices was never driven by economics.

Continuously increasing prices was a requisite for the purchase of homes with virtually no money down which led to more Americans achieving their right of home ownership (sarcasm). Had the Fed considered implementing a policy that contravened the cycle of increasing asset prices, they would have been slammed as a pawn of the rich and as having no concern for the economically less-advantaged.

So they did nothing and look where it got them.

I’m afraid the effort to re-write history on this particular aspect of the financial crisis, on the part of both pro- and anti- Fed camps, is misguided. The moment Congress imposed any responsibility for home ownership / housing prices on the Federal Reserve through the Home Ownership and Equity Protection Act (HOEPA), the Fed was screwed.

There are plenty of failures that fall under policies controlled by the Federal Reserve, I don’t think this is one of them.

Going to assume you think everything that moderates the tone of this particular argument is ‘right-wing’ garbage. I’m not claiming the Fed was correct in the non-response but they were never meant to win when it came to housing.

Plus, there are too many actual economic decisions to hold the Fed responsible for to muddy the waters will instances in which the Fed was a political tool (scapegoat). In this case, your elected officials, even the liberals, were the ones pushing for growth, growth, growth while at the same time eschewing any responsibility for the outcome of that growth.

And FYI, I’m about to walk to lunch, with women who don’t shave, at a restaurant that doesn’t serve meat, to laugh over the latest insights from Mother Jones. Maybe afterwards we’ll have latte’s and smoke a bowl before returning to work to help the homeless that were never intended to benefit from HOEPA.

Let’s see…..all these brilliant minds and this is what they come up with? “Whocouldaknowed?”

Back in 2005, I pondered, “My house is worth 4 x’s what I paid for it, 15 years ago. People are buying houses that cost 4 x’s what I paid for mine. Have their wages gone up 4 x’s? Answer- Not at all. Then how can this be sustainable?”

This isn’t “Economics for Dummies”. It is that hard. Even a layperson like me, who is simply in posession of a logical mind, could figure out that something was greatly amiss.

“(Note: the Fed has argued that information it gleans as a regulator is important in the formulation of monetary policy. In fact, this is the principle argument it has used for retaining a regulatory role.)”

This seems to be a theoretical consideration which they are prepared to ignore in practice.

The Greenspan/Kennedy study of home equity withdrawals showed that those withdrawals had gone from $56.7Billion in 1991 to $116.7Billion in 1998 and then to $245.7Billion in 2001. This rise was about a factor of 2 in 7 years and another factor of 2 in about 3 years. Obviously the withdrawals were not increasing linearly. (That study was done later but the data should have been available.)

Note: I use data from lines 3 (Home Equity Loans) and 4 (Cash-out Refinances) from table 2 on page 16 and include line 31 from table A-2 on page 42 which are dollars from a sale which were used for Personal Consumption Expenditures.

Or perhaps they should have looked at the effective Fed Funds Rate (eFFR) starting about 1980.
See this link: http://research.stlouisfed.org/fred2/series/FEDFUNDS
Note that the eFFR had been trending lower since 1980. The peak eFFRs were never rising to previous peaks. The eFFRs at the troughs were always lower than the previous troughs. Starting back in 1980 the Fed had been moving down the curve toward 0%. (So far, so good, said the man as he fell past the 37th floor!)

That information should have left them very nervous and much more willing to look under the rocks. Their defense would probably be that high unemployment rates were restraining their ability to raise the eFFRs.

But what was the plan, did they think that this could go on forever? At some point the politicians would have to face reality. The real economy was in serious trouble and jacking it up with the Fed Fund Rate had limits.

In late 2001 they could have refused to lower the Fed Funds Rate lower than the previous trough. Or they could have rushed to the Congress to report the problem with the same dire warnings that they used when demanding the bailout of the financial system. We could have started to have a conversation about what was wrong with the real economy.

How many foreclosures and unemployed would have been avoided by dealing with this problem a little earlier?

In late 2001 they could have refused to lower the Fed Funds Rate lower than the previous trough.

IMHO while cheap money might have started the bubble and lubricated it, it in no way can explain the actual price increases. It’s easy enough to see from mortgage tables. I think the bulk of hte explanation is the extension of credit to buyers who couldn’t make payments on income alone.

If economics were really a coherent science, and approached things methodologically, the Fed would be taking statistical samples of mortgages and examining them. They’d have noticed the huge upsurge in liar loans and the increased multiples of loan size over income. At that point—IIRC the Fed has the power to do this—they would have taken action against that.

Deregulation and fraud undoubtedly contributed to the housing bubble but the cause of the bubble was a consumers desire to extract cash from their homes and low interest rates which allowed them to do that with minimal affects on the size of their loan payments.

The real issue is why did consumers desire to extract cash from their homes?

In 1984 the personal savings rate was 10.4% but by 2005 it was .5%. (It was reported as -.5% in 2006 but the Bureau of Economic Analysis Department of Commerce revised their methods and magically the 2005 number was changed to +.5%)

After 1984 consumers were in trouble, initially they saved less to maintain their living standard. Then in the late 1990s they started to remove equity from their homes so that by 2005 they were removing about $575Billion per year. That borrowing was an attempt to maintain their living standard.

Consumers were wrong, they should have cut their expenditures. But the ‘powers that be’ should have been more that a little concerned about the middle class’s stagnant incomes.

When you combine the lower personal savings, home equity withdrawal, stagnant middle class incomes, and the Fed’s continuously rising stimulus to the economy via lower and lower interest rates, you have to wonder why the Fed was so quiet. They acted like a deer caught in the headlights!

I conclude that our current predicament is due to moving production overseas at an accelerating pace beginning in the mid 1980s and 12 to 15 million illegal immigrants working in this country by 2005. I am prepared to accept some other reasonable explanation but not the standard Washington bullshit.

The two obvious alternatives are that the Fed saw the signs but didn’t recognize it, which is incompetence, or knew this was lying to keep up prices but decided dishonesty is part of business, which is corruption.

Another possibility is that this statement by the Fed is just expressing personal feelings, not being all hard and fast about reality, and we should use our emotional intelligence to understand.

At a PRIMIA seminar in New York held in September 2007, one of the participants mentioned that while working at the Atlanta Fed several years before the sub-prime melt-down, the talk within the Fed was that they thought the real estate market was frothy and that something was going to give at some point.

So at some point the chit chat at the Fed was that the RE market was overdone, it just never made it to any official notice or publication.

My guess working in corporate hierarchies is that official word was quashed at senior levels, fearing some backlash from vested interests such as mortgage financing, structured finance, home building, realty etc.